Changes to the taxation of UK real estate held by non-UK residents: a real estate finance perspective

As part of the Autumn Budget on 22 November 2017, the UK Government announced significant changes to the UK taxation of capital gains realised by non-residents from direct and certain indirect disposals of UK property which will have effect from April 2019. Although it was clear that the Government intended to push ahead with the principle change of bringing gains realised in relation to such disposals within the charge to UK tax, a consultation was launched to solicit views on some of the detailed implementation provisions.

On 06 July, the Government published its response to the consultation on the new rules, alongside draft legislation covering some (though not all) aspects of the changes.

The new rules have the potential to impact significantly on the UK tax liability of non-residents holding real estate across the whole spectrum of structures through which UK property is currently held, and as such REF lenders should expect their borrower clients to be paying close attention to developments.

There will now be a further technical consultation on the draft legislation and the Government’s further proposals. As summarised below, it seems that the Government has taken on board feedback from the initial consultation concerning various problematic aspects of the original proposals. Nevertheless, with less than 12 months to implementation, non-resident investors in UK property should be considering the potential impact of these changes for their existing and planned investments, and whether, in particular, it will be necessary to consider a restructuring of existing arrangements.

Although some of the changes now proposed may decrease the sense of urgency felt by some borrowers to restructure, lenders should consider how their borrowers may be affected by the new rules and (in some cases) expect borrowers to be seeking engagement on the way forward in light of the revised proposals.

Direct disposals

Direct disposals by non-residents of investments in UK land, whether residential or non-residential, will be within the charge to UK tax with effect from April 2019. This extends the charge to tax on non-residents to commercial property for the first time.

The draft legislation confirms that, in the case of assets already held as at April 2019, any gain will be calculated by reference to April 2019 market value, subject to an option to apply historic cost (preventing the possibility of a taxable gain arising which is in excess of the non-resident’s economic gain if the asset stood at a loss in April 2019). However, electing to use historic base cost will at best reduce the gain to zero - it cannot create a capital loss.

Indirect disposals

• With effect from April 2019, non-residents will be liable to UK tax on a disposal of an interest in an entity which directly or indirectly derived at least 75% of its value from UK land at the time of disposal. However, in the light of responses to the consultation, a number of changes have been made to this aspect of the rules: the charge will only now apply if a 25% or greater interest was held by the non-resident and certain connected persons at any time in the previous two (rather than five) years.

• In assessing whether the 25% threshold is reached, the definition of persons who are treated as “connected” has been narrowed significantly. In particular, there will be no aggregation of interests merely by reason of being partners in the same partnership.

• There will be an exemption for disposals of interests in entities which use UK land in a trade. This is intended to simplify the application of the new rules to investments in land rich businesses, such as supermarkets. There is no proposal to provide a specific exemption for infrastructure projects. However, this “trading exemption” may apply where the infrastructure is used as part of a trade.

Double tax treaties

The new rules will contain an anti-forestalling provision to prevent structuring on or after 22 November 2017 in order to benefit from one of the limited set of UK double tax treaties under which the UK is not entitled to impose tax on gains from indirect disposals of UK land.

The UK-Luxembourg double tax treaty is the most obvious example of such a treaty and the Government has confirmed that it is in discussions with Luxembourg to amend this treaty to preserve the UK’s taxing rights over indirect disposals of UK land. It is prudent to assume that structures in existence prior to 22 November 2017 may not, therefore, be grandfathered. (Based on our experience on some recent real estate finance transactions it is not clear that all borrower advisers are making this assumption, so this may be a point to watch.)

Exemptions

Non-residents currently exempt from UK tax on gains (otherwise than because they are non-resident) will remain exempt from tax on both direct and indirect disposals. This means that investors granted sovereign immunity from UK direct taxes should be exempt in relation to such disposals, as well as non-UK pension schemes which meet the somewhat restrictive current definition of “overseas pension scheme”. However, the Government appears open to further representations with regard to extending exemption to wider categories of overseas pension schemes, which would help to ensure that UK real estate investments remain attractive to the broadest possible range of international institutional investors.

Partnerships, JPUTs and other collective investment vehicles

The original proposals caused considerable concern that existing property holding structures using partnerships and Jersey property unit trusts (JPUTs) would become very tax inefficient for tax exempt investors, potentially introducing UK tax leakage which would not be suffered if such investors held UK property directly, and that fund structures could suffer multiple tiers of taxation. It seems that the Government has taken these points on board, and now intends to mitigate some of the potential consequences.

There appears to be no intention to change the existing transparent treatment of partnerships for chargeable gains purposes: a disposal of a UK land directly held by a partnership will still be treated as a disposal by each partner of its proportionate share in the UK land. As the consultation response notes, the UK’s classification of non-UK entities owning UK property as transparent or opaque for relevant purposes will be increasingly important when analysing the impact of these rules, and it may be that borrower groups will need to apply for foreign entity classification rulings in relation to less frequently used entities.

The consultation responses highlighted the potential negative impact of the new rules on investments held in UK land held through collective investment vehicles which, unlike partnerships, are not transparent for chargeable gains purposes, or which hold interests via underlying investment entities (which might be put in place to facilitate the sale of individual properties).

The Government has been engaging with stakeholders in relation to issues raised by collective investment and is considering how to address these issues.

The current proposals, which are now subject to further consultation, are as follows:

• Entities such as JPUTs qualifying as “transparent offshore funds” would be able to elect to be treated as transparent from the perspective of non-UK resident investors. This would allow exempt investors in such funds to avail themselves of the exemption for disposals of UK land by a JPUT in which they hold units. Oddly, the consultation document suggests that this exemption will only be available in respect of non-resident investors - the position where a UK pension fund invests into a JPUT will need to be clarified, as we would expect that no asset level tax would apply in either scenario.

• Entities qualifying as “offshore funds” (whether transparent or opaque) and which are not closely held would be able to elect for special tax treatment under which gains realised by the fund or within its structure would not be taxable. Instead an investor would be taxed on disposal of their interest in the fund, based on the value of that interest, not the underlying UK land. This treatment would be subject to reporting obligations.

  The concept of “closeness” would be based on similar requirements to the close company requirement applicable for UK real estate investment trusts. As such, these proposals could allow funds to qualify even where under the ownership of only a small number of institutional investors.

  For underlying entities disposing of UK land which are not wholly owned by the top-level fund, exemption at the level of the entity would be proportionate to top-level exempt fund’s holding in the underlying entity.

• The exemption for indirect disposals where an interest of less than 25% has been held will not apply to interests in funds. The Government is considering whether it would be appropriate for funds to withhold tax on redemptions, potentially reducing the need for small retail investors to report and pay tax directly on their gains.

In the wake of November’s announcement, it was anticipated by the UK property industry that many fund structures would consider converting their existing arrangements into UK real estate investment trusts (REITs) to mitigate the UK tax costs imposed by the new rules, and we understand that some borrower groups have been actively considering this approach. The revised proposals may provide an alternative route for mitigation, and as such should be followed closely.

Assuming that the proposals to allow for elective tax transparent treatment are taken forward, lenders should consider whether they might require borrowers in this category to make such an election, in order to ensure that tax leakage is not suffered at borrower level (this could be particularly relevant to mezzanine lenders who are structurally subordinated).

Property income

In a parallel change, from April 2020, non-resident companies carrying on a UK property business will be within the charge to corporation tax, such that rental income will be subject to corporation tax rather than income tax. This will have significant implications: most notably affected taxpayers will for the first time be subject to the UK’s corporate interest restriction rules, which already apply to UK borrowers. Lenders may already be familiar with these rules, but non-UK borrowers will be addressing these new requirements for the first time.

Helping borrowers with tax compliance

Lenders will need to consider whether additional contractual provisions are appropriate in facility agreements in order to help ensure that non-resident borrowers are on top of their new UK tax compliance obligations (especially during the transition to the new regime). This might take the form of additional representations, undertaking and / or conditions precedent.

Listen to our recent webinar on "Draft Finance bill Real Estate changes" here.